Section 2.1.30 Sources of Finance: Internal and External Flashcards
sources of finance
wherever the money comes from that a business needs
what do new businesses starting up need
- money to invest in long-term assets such as buildings and equipment
- cash to purchase materials, pay wages and pay the day-to-day bills (e.g. water and electricity)
what do inexperienced entrepreneurs often underestimate
the capital needed for the day-to-day running of the business
if the income from sales is greater than the operating costs, what does this mean
the business is making a profit. this should be kept and used to finance growth
what are other situations where the business will need additional funding
- cash flow problem
- a major customer refuses to pay for goods, causing a huge gap in cash inflows
- large order, requiring the purchase of additional materials
finance for business comes from two main sources:
1) inside the business: internal finance
2) outside the business: external finance
capital can be generated from within the business in three ways:
1) retained profit
2) sale of assets
3) improved management of working capital
(4) share capital)
two sources of external capital:
1) loan capital (debt)
2) share capital (equity)
external sources of finance include:
- family and friends
- banks
- peer-to-peer funding
- business angels
- crowdfunding
- other businesses
family and friends
can provide share capital (taking an equity stake in the business and its profits) or can lend money
banks
- very hard to get a bank loan
- if you can get one, bank will insist on rock-solid collateral
- banks are not interested in sharing the risks involved when starting a business. they want to provide finance, not become a partner
peer-to-peer funding
- if there is an attractive-sounding business, it seems to work well
- online matching platforms to match individuals who want to lend (at a relatively high rate of interest) to individual business borrowers
business angels
- take huge risks in the hope of the occasional blockbuster success
- in reality, the only businesspeople likely to find an angel investor are those whose families move in wealthy circles
crowdfunding
a way of getting small investors to put money into a new business - often with an incentive, such as to get a sample product or service in return for their investment
other businesses
some companies allocate a chunk of their capital to early-stage investments. the companies hope to get the occasional winner from among a number of duds
external methods of finance include:
- loans
- share capital
- venture capital
- overdrafts
- leasing
- trade credit
- grants
loans
- most usual way is through borrowing from a bank : either in the form of a bank loan or overdraft
- loan is usually for a set person’s of time:
: short term - one or two years
: medium term - three to five years
: long term - more than five years - loan can be repaid in either instalments over time or at the end of the loan period
- the bank will charge interest on the loan - fixed or variable - bank will demand collateral to provide security in case the loan cannot be repaid
share capital
- comes from private investors or venture capital funds
- venture capital providers are interested in investing in businesses with dynamic growth prospects - willing to take a risk on a business that may fail, or do really well
- once it has become a public limited company, the firm may consider floating on the stock exchange
loan capital vs share capital
loan capital:
- won’t dilute control of founder
- makes no claim on the company products
share capital:
- no need to repay
- dividends can be cut: flexibility
can bring wise heads into boardroom
venture capital
- way of getting outside investment for businesses that are unable to raise finance through the stock market or from banks
- venture capitalists invest in smaller, riskier companies
- to compensate for their risks, venture capital providers usually require a substantial part of the ownership of the company - also likely to want to contribute to the running of the business - dilutes owner’s control but brings in new experience and knowledge
- venture capital houses typically put money into businesses that have survived early stages and are looking to grow
overdrafts
- facility that allows a company to spend up to an agreed negative balance on its current account
- when the bank balance is negative, company is overdrawn and must pay interest calculated on a daily basis
- bank can dip in and out of ‘the red’ so its interest bill at the end of the year will usually be quite a lot lower than with a bank loan
- overdrafts are flexible and well matched to the ups and downs of small company cash flow but the risk level should not be underestimated
-overdrafts are on 24-hour recall so the bank can cancel them at any time, often leaving business unable to pay negative balance and forcing business into administration
leasing
- leasing the asset means agreeing to pay a fixed monthly rental for a fixed period of time
- good for small or fast-growing businesses
- many firms short-term needs outweigh long-term wishes
trade credit
- simplest form of external financing
- business obtains goods or services from another business but does not pay for these immediately
- good way of boosting day-to-day finance
- other businesses may be reluctant to trade with the business if they do not get paid in time
grants
- hand-outs to small firms, either from a local authority or central government
- may be given to encourage a start-up or relocation that is considered valuable - probably because banks refused to lend
